Why being defensive has played well in this rally

Commentary: Current bull market shows historical anomaly

By

J.J.Zhang

Columnist

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

My previous article, “A stock strategy to weather the downturn,” went through an analysis of how various sectors perform during market downturns, particularly defensive stocks. The results were pretty strongly on the side of defensives as they outperformed the S&P 500 by 4 to 6 percentage points and outperformed cyclical sectors by 5 to 10 percentage points.

This, of course, raises the opposite question: what happens during market rallies? Conceivably, the rank order of sector performances should be opposite. Based on the same theory that noncyclicals produce products that are always in demand regardless of economic conditions, cyclicals should be highly driven by growth or at least prospects and expectations of growth.

Industrials and materials should grow due to expansion of plants, capital and equipment that comes with improvements in manufacturing and production. Additionally, a growing economy also produces more wealth for consumers, translating into stronger retail results, especially at the higher luxury end. Financials may also benefit as wealth, credit, and debt based purchases also rise.

Historical results

Looking at the S&P 500 over the last 10 years, there were several large market rallies. Picking 10 of those, we find most of them showed a roughly 10%-20% gain during the run.

There were a couple of massive rallies however, jumping approximately 40% and 70% before a major drop. Both of these jumps were recovery rallies, following market recession bottoms in 2003 and 2009.

Though it can be difficult to decide where a rally specifically begins and ends, the most relevant measure is how the various sectors perform relative to the overall market in that same time period.

The chart below shows the over and underperformance (including dividends) of all the major sectors, plus the bond market via the ETF AGG
AGG, +0.39%
, during those rally periods vs. the S&P 500 index. The sector ETFs were chosen from SPDR’s offerings for consistency and completeness as they span the broad range of categories from materials
XLB, -0.26%
to energy
XLE, -2.19%
to utilities
XLU, +1.01%
.

Relative to the S&P benchmark, the sectors that did the best during market rallies (excluding the extreme and nonrepresentative outlier results from the 2009 recovery) were materials, financials, industrials and technology, in that order. These sectors outperformed the S&P by approximately 2-5% on average.

The sectors that did the worst were utility, consumer staples and health care, underperforming the S&P by 6-7% on average. Bonds as expected did the absolute worst, underperforming the S&P by 16%.

Energy and defensives

Surprisingly, the energy sector performed poorly during market rallies, sporting only a 1.6% outperformance on average and a -1.9% underperformance on median. In contrast, materials, which many consider the twin to energy, outperformed the S&P an average of 4.6% and a median of 4.3%.

So while a growing economy needs both energy and raw materials to create products and services, energy stocks are not quite as lucrative.

The underperformance of bonds and defensive sectors such as utilities, consumer staples and health care is not surprising, especially in light of their stronger results during market downturns. Of the three, health care did the best with an average performance -6.1% and a median performance of -3.7%.

Note that these figures are performance relative to the S&P, not their total return. These sectors still did well overall during these rallies, rising 15-17% (including recession recoveries) and 8-12% (excluding recession recoveries), a more than respectable result.

One of the most interesting exceptions to the historical trend is actually the current rally. While the defensive sectors underperform the S&P in all historical rallies, they are actually outperforming in the current rally, beating the S&P by 2-5%.

On the other side, though materials and tech typically outperform during rallies, they are currently down 4-7% vs. the S&P, the lowest recorded. These hint that the current rally is somewhat unusual compared to historical trends.

Conclusions

As always in financial matters, past performance doesn’t guarantee future results, and there are many cases where the performance deviated from the average. However, looking over the results over the past 10 years, there is a general trend which matches the conventional wisdom of cyclicals outperforming during market rallies.

On average, sectors such as financials and materials outperformed the S&P by approximately 3-5%, followed by tech, industrials, and consumer discretionary at approximately 2-3%. Utilities and consumer staples bring up the underperforming rear by -8%, with the exception of the current rally.

Though the defensives generally underperformed the index, they still delivered strong total returns as per the saying, “a rising tide lifts all boats.”

J.J.
Zhang

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

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J.J.
Zhang

J.J. Zhang is chemical engineer and amateur financial adviser who was the winner in MarketWatch’s second annual World’s Next Great Investing Columnist contest. He runs the blog MarketTech Reports. You can follow him on Twitter @MarketTechRpts.

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